Theories of Sources of Comparative Advantage

References:
Carbaugh: Chpt 3
Krugman: Chpt 7
Key Questions:
What accounts for different CA in different countries?
How does trade affect the relative welfare of the trading nations?
How does trade affect the relative welfare of different sectors within
the same economy?

(I) Overview of Theories of CA

Two main theories: Ricardian and Heckscher-Ohlin
Other theories: Imperfect competition, specific factor, product cycles etc
What about theory of competitive advantage?

(II) Ricardian Trade Theory

Differences in CA are caused by differences in relative labor productivity.
Country should export goods in sectors where its relative labor
productivities are higher than those in other countries.
(A) Basic Model
Assumptions:
2 sectors (Food and Cloth)
Single factor: Labor. Wage is the main component of national income.
Multi-factor model: Other factors matter too -- could affect labor productivity
and offers more comprehensive explanation

Notation:
Labor productivity measured by Unit Labor Requirements (ULR): Number of
labor units required to produce one unit of good
lF : unit labor requirement in Food production
lC : unit labor requirement in Cloth production
PF : price of Food
PC : price of Cloth

w: wage rate
Foreign country: same notations except with *

Equilibrium condition in production

Profit maximization: MC = MR (in perfect competition, AC = AR also)
Home country:
Foreign country:

w lC = PC and w lF = PF
w* lC* = P*C and w* lF* = P*F

APR in the two countries:

Home country: APR = Pc /PF = lc/lF
Foreign country: APR* = P*C /P*F = l*C/l*F

Food

Ricardian Model: Autarky

PPF

APR: slope = lc / lf
CIC

Cloth
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Trade Equilibrium
Ricardian theory: CAs between two countries are determined by the
difference between (lC / lF ) and (lC* / lF*)
As long as (lC / lF ) and (lC* / lF*) are different, it is beneficial for the two
countries to specialize and trade
After trade, the two APR should converge to one international price ratio, TOT
Note that (lC / lF ) > (lC* / lF*) : Relative to foreign country, home has CA in food
production
After trade, Home will export food and import cloth

Ricardian Trade Equilibrium

Food
Assume home country is small economy

APR: slope = lC/ lF

CIC

CIC
PPF
A

TOT: slope = lC*/ lF*

Cloth
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(B) Wages and Productivity

Recall that in equilibrium
Home country:
Foreign country:

w lC = PC and w lF = PF
w* lC* = P*C and w* lF* = P*F

After trade, PC and P*C converge (as do PF and P*F )

Thus relative wages in 2 countries: w / w* = lC*/ lC = lF*/ lF

Relative wages completely determined by relative labor productivity

Home country with higher labor productivity can have high wages than
foreign country without losing export competitiveness.
To increase competitiveness in the market, a country has to increase labor
productivity. What about wage cuts?
What are the options if w lC > PC ?

What determines labor productivity?

Technology and innovation?
What determines technology and innovation: Government policy?
Education? Culture?
Infrastructure: soft and hard infrastructure?
Some Misperceptions about Trade, Wages and CA
Free trade is good only if home can stand up to foreign competition
Trade based on low wage is unfair to other countries
Trade leads to exploitation if home workers receive lower wages than
workers in foreign countries

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(III) Heckscher-Ohlin Trade Theory

Theory:
A countrys CA is determined by the relative proportion of various factors of
production that it is endowed with;
A country should export goods which use intensively its abundant factors in
production, and import goods which use intensively its scarce factors in
production
Developed by Eli Heckscher and Bertil Ohlin (Factor Proportions theory)
A multi-factor model and hence can address income distribution effects of trade

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(A) Key concepts:

Abundant (scarce) factor: factor in which a country has a relatively larger
(smaller) supply compared with other countries
Factor abundance is country-specific. Need to know which two countries
are being compared
Factor Intensity: If, at any given factor prices, the production of good F always
involves a higher capital/labor ratio than good C, the good F is considered
capital intensive.

H-O theory suggests: If 2 countries have different K/L ratios, they will have
different autarky price ratios and hence different CA in goods that are
produced with different factor intensities. If they specialize and export based
on that CA, both countries will gain (reach higher CICs)
Diagrammatical illustration

12

Two countries, with different PPF and autarky prices

Homeland
Food

I1

Abroad
Food

I2 I3

I1

I2 I3

A
p*

A*
p
Clothing

Clothing

Trade takes place with equilibrium TOT

Homeland
Food

I1

Abroad
Food

I2 I3

I1

I2 I3

P
A
C

C*

A*
P*
pW
Clothing

pW
Clothing

Gains from Trade due to different PPF

Homeland
Food

Abroad
Food

I1 I2 I3

I1 I2 I3

P
e
x
p

A
C

C*
i
m
p

A*
P*

pW
imports

Clothing

pW
exports

Clothing

(B) Product Price and Factor Price

H-O theory suggests that, with trade, a country tends to export its abundant
factor, as embodied in its exported goods; and import the scarce factor, as
embodied in the imported goods. This implies

Trade in goods can be substitute for trade in factors

Factor prices across countries tend to converge with trade (factor price
equalization theory)

Policy implication: Restrictions in cross-border factor movements can be

overcome by trade in goods though this takes a longer time.

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(C) Trade and Income Distribution

Trade raises prices of abundant factors and lowers prices of scarce factors
(relatively) within a country (Stolper-Samuelson Theorem)
Friction caused by trade among different groups in the same economy
Implications for protectionist trade policies
Could trade widen income gap?
Trade generally reduces income inequality within a country
But trade could also worsen income inequality within a country
depending on the pre-trade relative prices if abundant factors are
already more highly paid than scarce factors.
Broader definition of labor and capital

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(IV) Imperfect Competition and Scale Economies and Trade

(A) Overview
Ricardian and HO theories
Assume constant return to scale (CRTS) in production and perfect competition
CA and trade pattern changes only with changes in resource endowments
and/or technologies
Explain only inter-industry trade among countries with different resource
endowments or technologies
In reality, we observe
Existence of imperfect competition and increasing returns to scale (IRTS)
CA and trade pattern can change over time even without changes in resources
or technology
Widespread intra-industry trade among economies with similar resource
endowments and technologies
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Increasing Returns to Scale (IRTS)

Allowing for imperfect competition and IRTS helps provide more comprehensive
explanation of trade patterns
Production becomes more efficient the larger the scale i.e. increase in inputs
leads to more than proportionate increase in output
Average cost (AC) curve is downward sloping
Internal IRTS: Average cost of production (AC) depends on size of individual
firms, not necessarily size of industry
Often results in monopolistic market structure (i.e. monopoly, oligopoly or
monopolistic competition) to capture scale economies
External IRTS: Average cost of production (AC) depends on size of the industry,
not necessarily size of individual firms
Individual firms may remain perfectly competitive
No advantage in being a large firm. There can be many small firms in the
industry e.g. Silicon Valley
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(B) Internal Increasing Returns to Scale and CA

Assumptions
2 countries, 2 goods (manufacturing and food)
Home: capital abundant; Foreign: labor abundant
Manufacturing: capital intensive; Food: labor intensive
Internal IRTS in manufacturing
Results in monopolistic competition, with firms producing differentiated
products within the same industry
Trade Equilibrium
H-O theory: suggests
Home exports manufacturing, imports food
Foreign exports food, imports manufacturing

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With Internal IRTS

Trade increases the total market size, allows firms in both countries to
specialize within a certain range of products and exploits Internal IRTS
Home still exports manufacturing, but NOT the whole range; Foreign also
exports some manufacturing goods (See Diagram)
Two parts of trade
Inter-industry trade: based on traditional CA
Intra-industry trade: based on Internal IRTS
Relative importance of the 2 types of trade depends on similarity/differences
between the 2 countries
The more similar (in endowments or technology), the more important is
intra-industry trade
Similarity in technology or resource endowment will not rule out trade

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Trade in a World Without Increasing Returns

22

Trade with Increasing Returns and Monopolistic Competition

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Policy Implications
Help explains a sizeable part of international trade in the world, especially
similarly endowed economies e.g. European countries
Developed economies become more similar over time, yet trade volume
does not diminish. Implications for Asia?
Industrial adjustment problems are less severe in intra-industry trade: interindustry requires movement of resources from different industries.
Certain factors esp labor are not mobile (either occupationally or
geographically) in short run; structural unemployment severe
Effects on income redistribution less severe (since intra-industry trade takes
place within same industry and involves the same factors); makes free trade
policy more acceptable politically

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Indexes of Intra-Industry Trade for U.S. Industries, 2009

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(C) External Increasing Returns to Scale and CA

Sources of External IRTS
Derived from agglomeration effect that may arise from
Specialized suppliers
Labor market pooling
Knowledge spillover
Important for innovation-driven businesses

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Implications for Trade Pattern

External IRTS tends to result in geographical concentration of production as
countries get locked in to a particular production (See Diagrams)
As production scale increases, agglomeration effect takes place, AC falls and
CA strengthened
More firms attracted to same locality, production expands further. Other
countries find it hard to enter and compete with incumbent
Cross-border mobility of factors of production (e.g. capital and labor) will
reinforce the effect of external IRTS i.e. more rapid agglomeration
Examples; London as global financial center; Hollywood as global film
production center

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External Economies Before Trade

28

Trade and Prices

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Implications of Geographical Concentration of Production

External IRTS could lead to winner-takes-all outcome
Initial position matters.
Concept of first mover advantage
What accounts for initial advantage? Natural CA?
Accident of history?
Resources needed for production is available in a particular country only
Large domestic market size helps as it brings down AC
Government policies can play a role in acquiring first mover advantage
Strategic industrial policy?

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Implications for Trade Policy

External IRTS makes it less easy to advocate free trade policy
A form of market failure

Initial government help may be needed to break into market (See Diagram)
Once home country breaks into market, could wrestle the whole market
from incumbent producer: winner takes all for home country
Justification for strategic policy (protectionist policy) to secure critical
mass and first mover advantage
Competition among governments to establish first mover advantage
through various subsidies

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External Economics and Specialization

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 Protectionist policy (import substitution) might increase national welfare?

(See Diagram)
Some caveats
Difficult to estimate benefits of External IRTS
Retaliation by other countries

33

External Economics and Losses from Trade

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